Friday, January 11, 2013

With literally thousands of
stocks, bonds and mutual funds to choose from, picking the right investments
can confuse even the most seasoned investor. However, starting to build a
portfolio with stock picking might be the wrong approach. Instead, you should
start by deciding what mix of stocks, bonds and mutual funds you want to hold -
this is referred to as your asset allocation.

What Is Asset Allocation?

Asset allocation is an investment
portfolio technique that aims to balance risk and create diversification by
dividing assets among major categories such as cash, bonds, stocks, real estate
and derivatives. Each asset class has different levels of return and risk, so
each will behave differently over time. For instance, while one asset category
increases in value, another may be decreasing or not increasing as much. Some
critics see this balance as a settlement for mediocrity, but for most investors
it's the best protection against a major loss should things ever go amiss in
one investment class or sub-class.

The consensus among most
financial professionals is that asset allocation is one of the most important
decisions that investors make. In other words, your selection of stocks or
bonds is secondary to the way you allocate your assets to high and low-risk
stocks, to short and long-term bonds, and to cash on the sidelines.

We must emphasize that there is
no simple formula that can find the right asset allocation for every individual
- if there were, we certainly wouldn't be able to explain it in one article. We
can, however, outline five points that we feel are important when thinking
about asset allocation:

1. Risk Vs. Return

The risk-return tradeoff is at the
core of what asset allocation is all about. It's easy for everyone to say that
they want the highest possible return, but simply choosing the assets with the
highest "potential" (stocks and derivatives) isn't the answer. The
crashes of 1929, 1981, 1987, and the more recent declines of 2007-2009 are all
examples of times when investing in only stocks with the highest potential
return was not the most prudent plan of action. It's time to face the truth:
every year your returns are going to be beaten by another investor, mutual
fund, pension plan, etc. What separates greedy and return-hungry investors from
successful ones is the ability to weigh the difference between risk and return.
Yes, investors with a higher risk tolerance should allocate more money into
stocks. But if you can't keep invested through the short-term fluctuations of a
bear market, you should cut your exposure to equities.

2. Don't Rely Solely on Financial
Software or Planner Sheets

Financial planning software and
survey sheets designed by financial advisors or investment firms can be
beneficial, but never rely solely on software or some pre-determined plan. For
example, one old rule of thumb that some advisors use to determine the proportion
a person should allocate to stocks is to subtract the person's age from 100. In
other words, if you're 35, you should put 65% of your money into stocks and the
remaining 35% into bonds, real estate and cash.

Stock Watch List: CTLE

But standard worksheets sometimes
don't take into account other important information such as whether or not you
are a parent, retiree or spouse. Other times, these worksheets are based on a
set of simple questions that don't capture your financial goals. Remember, financial
institutions love to peg you into a standard plan not because it's best for
you, but because it's easy for them. Rules of thumb and planner sheets can give
people a rough guideline, but don't get boxed into what they tell you.

3. Determine Your Long- and
Short-Term Goals

We all have our goals. Whether
you aspire to own a yacht or vacation home, to pay for your child's education
or to simply save up for a new car, you should consider it in your asset
allocation plan. All of these goals need to be considered when determining the
right mix.

For example, if you're planning
to own a retirement condo on the beach in 20 years, you need not worry about
short-term fluctuations in the stock market. But if you have a child who will
be entering college in five to six years, you may need to tilt your asset
allocation to safer fixed-income investments.

4. Time Is Your Best Friend

The U.S. Department of Labor has
said that for every 10 years you delay saving for retirement (or some other
long-term goal), you will have to save three times as much each month to catch
up. Having time not only allows you to take advantage of compounding and the
time value of money, it also means you can put more of your portfolio into
higher risk/return investments, namely stocks. A couple of bad years in the
stock market will likely show up as nothing more than an insignificant blip 30
years from now.

5. Just Do It!

Once you've determined the right
mix of stocks, bonds and other investments, it's time to implement it. The
first step is to find out how your current portfolio breaks down. It's fairly
straightforward to see the percentage of assets in stocks versus bonds, but
don't forget to categorize what type of stocks you own (small, mid or large
cap). You should also categorize your bonds according to their maturity (short,
mid or long term). Mutual funds can be more problematic. Fund names don't
always tell the entire story. You have to dig deeper in the prospectus to
figure out where fund assets are invested.

The Bottom Line

There is no one standardized
solution for allocating your assets. Individual investors require individual
solutions. Furthermore, if a long-term horizon is something you don't have,
don't worry. It's never too late to get started. It's also never too late to
give your existing portfolio a face-lift. Asset allocation is not a one-time
event, it's a life-long process of progression and fine-tuning.